By Lauren Ziegler, Member at Nemphos Braue
You and two friends decide you want to start a new company. Congratulations! What comes next is critical – you’ll want to give your business a proper foundation for success by determining the roles, responsibilities, and rights of the founders and memorializing them in a founders agreement.
Why is now the right time to address a founders agreement? Founders agreements sometimes get a bad rap. While, yes, they address what happens if the founders no longer have a common vision for the company, or a dissolution of the partnership, founders agreements also address key fundamentals for a business’ operation, providing a framework for resolving conflicts and accounting for growth opportunities you may not yet see on the horizon.
What form does a founders agreement take? If your company is structured as a limited liability company, the founders agreement is called the operating agreement, which governs financial contributions, the entity’s ownership, and how decisions are made. Founders have a lot of flexibility in how they structure the governance of a limited liability company. The entity can be managed by the members, by a single manager, or by a board of managers analogous to a corporation’s board of directors. If your company is structured as a corporation, its management structure is controlled by state law and must consist of a board of directors and officers. The founders agreement for a corporation is typically called a stockholders agreement and deals with items like the composition of the board of directors and restrictions on transfers of stock. Both corporations and limited liability companies permit the owners to agree on certain management and voting decisions, and other restrictions relating to ownership interests. Most importantly, the founders agreement creates the framework for how future disagreements will be resolved.
What are some of the typical concepts that need to be addressed by founders? In part, founders agreements cover the basics that are a must for ANY company:
- Governance: Who has decision-making power? Who is going to run the day-to-day operations of the business? Your agreement may state that Founder A has responsibility in certain areas while Founder B oversees other areas. It could require that 2 out of the 3 founders must agree in order to enact major decisions (for example, hiring certain employees, bringing on investors, or selling the company). If you have a 50/50 partnership, the agreement will need to address how a deadlock will be resolved.
- Who contributes what to the business: Sweat equity, intellectual property, financial investment, or a combination of the foregoing? Will the founders’ equity be subject to time-based or milestone-based vesting terms?
In addition, a good founders’ agreement should address potential changes in the founders’ relationship over time:
- Restrictions on transferring ownership: You are choosing to enter into business with your co-founders, not unknown third parties, and will want to set up parameters around who can own equity in the company.
- What happens if a co-founder no longer wants to be involved in the business? Without the proper provisions in place, that founder can “walk away” and still own her interest in the company, capitalizing on the ongoing work of the other founders.
- What happens upon a co-founder’s death or incapacity? Does the company or the other founders have the right or the obligation to purchase the co-founder’s ownership interest? If so, how is the value of that interest determined?
- What if a majority of the founders want to sell the company? Can they force the other founders to participate in the sale?
- Should the founders be subject to non-competition and non-solicitation obligations?
Keep in mind that the expectations addressed by a founders agreement can often change or evolve as the business grows, so a founders agreement should not be viewed as a static document. If a company brings on equity investors, those investors will often want a say in decision-making and the economic and governance structure set up in the founders agreement may need to be reevaluated. Similarly, if one founder leaves the business, the remaining founders may want to rework the governance structure or address bringing on a new partner.
As a corporate attorney, my job is to make sure clients are aware of potential risks and mitigate as many of those as we can. Below are actual questions that I’ve seen come up with entrepreneur clients. Would you and your co-founders be prepared to answer them?
- Can your co-founder transfer all or a portion of her ownership interest to her spouse, giving the spouse decision-making authority over the business?
Can the majority owners sell their interest to a third-party, leaving behind the minority owners? - If a co-founder’s employment is terminated for cause, does the company or the remaining founders have the right to buy back the terminated co-founder’s ownership interest in order to eliminate any governance rights the terminated co-founder has as an owner?
- If a co-founder’s employment is terminated without cause, can she be forced to sell her ownership interest to the company or the other founders?
- A co-founder decides to leave the company and set up a competing business. Are there protections in place to prevent the co-founder from competing with the company or soliciting the company’s customers?
Founders agreements are highly individual and may require uncomfortable conversations, but with a good agreement in place you’ll be able to offer your new company stability and ensure that you’re in business with the right people.
Lauren B. Ziegler is a Member at Nemphos Braue, where she represents startups, emerging and mature private companies, and investors in a variety of corporate, securities and business law matters.
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